On Daruma's Watch

monthly small-cap insights for investment professionals

September 2008
Vol. 1 No. 1

Welcome!

The first edition of our monthly newsletter kicks off with a look at small caps and the credit crunch.

Please reply to share your comments, questions or objections.

All the best,

Mariko O. Gordon, CFA
Founder and CEO
Daruma Asset Management, Inc.

Small Caps And Credit... Not What You May Think

Have you ever tried to push a large dog? Believe me, it doesn't work.

I was reminded of this important point late yesterday afternoon, as I walked home from the office. It was a beautiful, late summer day, and as I headed up 105th Street, I spotted a young girl NOT walking her dog.

She was about eleven. His age was harder to estimate, but he was a huge Great Dane. And he was all but crazy-glued to the sidewalk.

He didn't seem anxious or upset. He wasn't trying to go in a different direction. And while I'm no Dog Whisperer, trust me, his body language screamed "I am staying put."

So I slowed up to watch this battle of wills.

The girl tried pulling him by the leash. Nada. She tried pushing him from behind. Nada. In desperation, she finally grabbed him by the middle and flipped him up onto his hind legs. They both stood there, panting, stuck.

Frankly, I don't know who ultimately won that contest (I have only so much dog watching time in my day), but it did bring to mind a question I was asked that very same morning: Will the credit crunch cause small-cap stocks to stop in their tracks?

Typically, small caps underperform large caps going into and outperform coming out of a recession. When times get tough, there's a flight to quality - if owning stocks at all is unappealing because the market is tanking, why not own blue chips rather than volatile and thinly traded small caps?

Smaller companies have fewer business lines, and because of the law of small numbers, have their financial results more easily buffeted about by Murphy's law. One or two orders that get pushed out can wreck a small company's quarter, whereas a big company has enough going on that the gap can be filled with unexpected pluses in their pipeline and the Street is none the wiser.

Small caps have been on a tear since the market bottomed out in mid-July, leaving many investors caught in a tug of war between fear ("this is a garbage rally, caused by short covering, which will promptly roll over because we're not out of this housing mess yet") and greed ("yippee, small caps are telling us we're heading out of the woods and we're on our way to a year like 2003, when the Russell 2000 was up 47%").

But would a worsening credit crunch really cause small caps to stall?

Conventional wisdom often contains a grain of truth, but I find that a lot of assumptions about small-cap investing are erroneous, and this is one.

While it's true that banks are tightening credit standards (too little too late) and that small businesses (we're talking mom and pops) are finding credit harder to get, that is not to say that small caps are suffering from the same ills. Your local dry cleaners is one thing. An $800 million market cap company with $500 million in sales is another.

Let's examine the facts:

Excluding the Financials, the average total debt to equity for the Russell 2000 is 41.8% versus 147.3% for the S&P 500; the current ratio (a measure of short-term liquidity) is 3.2 versus 1.7, and the cash & equivalents to total assets is 21.1% versus 12.8%, respectively. Small caps are not more leveraged nor more in need of capital than their large cap brethren. They are thus no more vulnerable than large caps if the credit environment deteriorates further.

If a business generates cash flow and can self-fund growth then credit availability doesn't matter. It's a different story if a business is growing so fast it needs cash to fund its growth, either with debt or equity. But if it's growing fast in a lousy environment, chances are people will want to invest, and raising capital shouldn't be a problem.

However, if a company is leveraged and revenues are plummeting, then a credit crunch will put it out of business, regardless of size. Just being big doesn't protect you from extinction in tough times. (Remember the dinosaur?)

In a rapidly changing world companies that are both nimble and unencumbered by legacy assets can often function better, particularly in newer industries. Though to be fair, in mature areas of the economy the forces of entropy help those with large, well-established market share.

Personally, I find the idea of trying to perfectly time rotations in and out of asset classes counterproductive.

A good asset allocation plan with rebalancing will keep you sane, whereas constantly trying to read the tea leaves to guess the sector to rotate into won't. No one expected the Russell 2000 to outperform the S&P 500 this year - certainly not by the whopping margin of over 9 percentage points through 9/2/08.

Can you avoid some pain by staying out of small caps when there's a flight to quality? Sure. But can you be certain you'll reinvest in small caps when things look their bleakest in order to capture the upside? Maybe not.

Over the long haul small has done better than large, albeit with more heart stopping moments on both the up and downside, but for more complex reasons than mere credit availability.

If you ask me, fleeing the sector when credit gets tight makes about as much sense as pushing on a large dog.

Source: Factset, Reuters and Strategas.

Buried Treasure Found In Earnings Calls

We touch every company in our investable universe quarterly, by reading conference call transcripts that have been text-mined for sentiment. We are most interested in learning about new things companies are doing that may change their future financial results, such as changes in salesforce compensation, pricing, or distribution channels. Slogging through roughly 1500 transcripts a quarter can sometimes be tedious, but we never know what will trigger our next great investment insight.

Read along with us to see what nuggets of information can be unearthed from conference calls. The second quarter transcript of Barrett Business Services (BBSI), a company that combines staffing services with professional employer services, turned up an unusually eclectic assortment of tidbits.

In addition to the usual financial update, we get:

1. The status of Bill Sherertz, Barrett Business Services CEO's health: "As some of you may or may not know, two weeks ago I had major surgery on my spleen. They removed it."

Brownie points for full disclosure, unlike Apple.

2. Something worth checking out in IT services: "There must be some trend, and I would like to go back and figure out exactly what it is, but all of a sudden I am getting a lot of IT acquisitions of which I have zero interest. It seems like whenever those IT guys come along, there's something going on out there. Lately it has been more than just a few. It has been a lot. There was a lot of it right around Y2K, if you remember. I don't know what it says to me. Whether there is some kind of downturn coming with IT that they see or it is a coincidence, I can't put my finger on what it is. "

Hmmm... an image of rats fleeing a sinking ship comes to mind, and it's worth nosing around to see if there's something going on that could affect our technology stocks. Where there's change afoot, there's both danger and opportunity.

3. Something worth checking out in California: Insurers are exiting the worker's comp market in California, which is good for Barrett "...back in 2001 and 2002, in which there were no comp carriers literally in the state of California. We were just inundated with business - because they didn't have any place else to go."

It is a truth universally acknowledged that in bad economies, worker's comp claims go up. There may be something more than the economy driving insurers out of California, however, and we will follow up with the portfolio holdings potentially most affected. An exodus of capacity usually leads to better pricing and profits for those left behind, so we'll see if there's also an investment case to be made for certain insurance companies.

Source: FACTSET/callstreet, July 30, 2008

Notes From The Field

We learn many things from visiting companies, from the germane to the absurd. Brad McGill and I stopped by one of our companies' newest acquisition, a medical equipment plant bought from a Fortune 500 company in January 2008.

Since outsourcing manufacturing is a trend that's picking up steam, we wanted to understand better why the large pharma chose to sell, and how well our portfolio holding has integrated this purchase, given that acquisitions are key to its future.

A veritable thicket of no smoking signs surrounded the facility. We'd never seen such anti-smoking zeal applied to parking lots, where there was nothing flammable and the risk of harming others with secondary smoke seemed low. This was a legacy of big company paternalism we were told, and one of two things that changed almost immediately when the plant was sold. Employees can now smoke within a 500-mile radius of the plant.

The other, way more important change was the installation of a new Enterprise Resource Planning (ERP) system to replace a hopelessly antiquated computer system. The manufacturing manager was thrilled with the upgrade, and how smoothly it went, and so were we because we did not expect to find a cross-check on another portfolio holding, Epicor, (EPIC) the ERP software vendor, as part of our visit.

Moral: Don't assume that Fortune 500 corporations have up-to-date systems, though their signage is undoubtedly more thorough than that of small companies.

About Us

Founded in 1995, Daruma Asset Management invests in a high-conviction portfolio of no more than 35 small-cap stocks.

Our firm is 100% employee-owned, and manages $1 billion for public and corporate pension plans, endowments, foundations and individuals. Our small-cap composite has an annualized return net of fees of 13.5% vs. 8.1% for the Russell 2000 since inception (7/28/95 through 6/30/08). (Notes to Performance)

For more information about the work we do, please visit us here.